Estimating trade elasticities in MAKRO

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In this working paper, we estimate the elasticities of substitution of imports and exports used in MAKRO for the industries manufacturing and energy. The data used is from the inter- national trade database BACI and is available on annual frequency for the period 1995-2016. By using detailed trade data for many countries at the product level, the trade elasticities can be estimated while taking into account typical endogeneity problems and it allows potential problems with aggregation bias to be investigated and addressed. Our methodical starting point is Feenstra (1994), where the supply and demand curves are separately identified by utilizing the heteroskedasticity of shocks in the country dimension. The resulting import elasticity between domestic and foreign-produced manufacturing goods is estimated at 2.76. We then estimate the export elasticity as a weighted average of the import elasticity of Denmark’s 50 largest trading partners and obtain an estimate of 5.42 for the manufacturing sector. This estimated export elasticity is robust to an alternative assumption, that the elasticity is the same across the countries to which Denmark exports. For energy, we find elasticities of 3.50 and 5.03 for imports and exports, respectively. There are indications of aggregation bias, as the elasticity estimates are generally higher when more disaggregated data is used in the estimation.